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27 April, 2015  ▪  Lyubomyr Shavalyuk

Pressure, Procrastination and Neighbors' Best Practices

Economic reforms are slowly gaining momentum in Ukraine, but the results are not yet in sight

If the Revolution of Dignity was about ensuring a decent life for Ukrainians, then an essential indicator of this decent life is the decent level of income. More than a year after the revolution, the real income of Ukrainian citizens has dropped considerably, while the economic reforms designed to dramatically increase it are only coming into gear. To justify the saying that Ukrainians harness their horses slowly but drive them fast, the government is procrastinating with the launch of the market reforms. Time will tell whether the government will drive fast.

As of today, the economic reforms in Ukraine have a few general features that will determine their course and have an impact on the overall success of the transformation. Firstly, a significant number of changes is carried out under pressure, primarily from the IMF (lending programs) and the EU (Association Agreement). Experience shows that Ukrainians often work harder when having a supervisor hovering over them, therefore, the tight deadlines and strict requirements set by the Western countries and international organizations will definitely contribute to the deployment of the reforms and increase their chances of success.

Secondly, the Ukrainian authorities have a clear idea of ​​where we are going in terms of quantity (income levels and some other macroeconomic parameters are well described in the Strategy-2020), but a vague perspective on what country we want to build in terms of quality (which key industries to develop, what kind of business to be given priority, what model of regional development to choose, etc.). Many economists blame them for that. To some extent they are right, but taking into account that the reforms have been launched on a broad front and, above all, are designed to "break the ground" for the new country, clearing it from the wreckage of the past, it's probably not the right time to raise these issues. We will come back to them later, if the first phase of the reforms proves to be successful.

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Another side effect of focusing on quantitative rather than qualitative indicators is that reforms are often perceived as working with macroeconomic indicators and leveling them out manually and formally, for instance, by increasing budget revenues or cutting spending, rather than changing the quantitative and structural factors that determine the performance of the economy. These false targets allow for making cosmetic repairs of the system, but not for bringing about a radical change. They are very misleading and hinder the change process by absorbing too much social energy.

Thirdly, it often seems that the government or some of its representatives have no idea what to do next. This is only normal, since they had never before carried out profound reforms at the national level. This, too, could have become another stumbling block in the way of economic reforms, had not the country's leadership learned to listen to the advice of successful reformers from the neighboring countries and to trust their competence. The significant number of foreigners present today in Ukraine in key government positions and in the capacity of advisers with a real voting power is an absolute step forward aimed at overcoming the theoretical ignorance and the lack of practical experience.

Finally, the economic reforms, likely to the transformations in the other areas of responsibility of the state, have to overcome an overwhelming resistance of the officials, oligarchs and other wolves in sheep's clothing entrenched in the government, which is reform-minded in general. This greatly hinders the reform process, even though giving more time to better interpret and design it, considering all pros and cons. The resistance of civil saboteurs is no longer sufficient to completely halt the transformation, but is still strong enough to slow down its pace to a minimum that will be almost imperceptible to the public.

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A standard set of changes

At long last, we have to admit that the reforms are underway. They have been launched on a broad front and cover many areas. Each of those areas has its own wins and failures, so it is worthwhile mentioning all of them.

Staff reform. The central government agencies (Presidential Administration, Cabinet of Ministers, National Bank of Ukraine, etc.) began a large-scale restaffing effort. Obviously, the middle management that worked under the old system, in addition to low wages often had its own vested interests. They were utterly interested in making "reforms" without real changes, and therefore had to be replaced with the young, hard-working, efficient, and energetic. As of today, the restaffing at the level of the heads of departments and offices took place almost in every agency of the central administration. According to government officials, in some cases they had to build the HR function literally from scratch, since previously the new employees would take positions at the Cabinet or the National Bank at the order of a newly appointed manager, with no one checking their competencies or their compliance with job descriptions. Although a lot of people still need to be replaced, and the more people are replaced, the higher will be the personnel shortage in the country, the process is already underway, and today there is little doubt that market reforms in Ukraine will be supported by the adequate and highly qualified personnel.

Tax reform. Most changes to the tax law were passed when the 2015 budget was voted in the last days of the last year and the amendments thereto a month ago. Those changes were an IMF requirement and are aimed at filling the state budget in the time of war and recession. There have also been a few structural changes, such as eliminating several taxes and charges, bringing the number of the remaining ones to 9, simplifying tax returns and reducing the time required to file them, radically cutting the unified social tax rate (given the respective increase in gross wages) and passive income tax rate, etc. However, these changes are fragmented and will not reform the tax system as such, which today is focused primarily on fiscal functions, i.e., filling the budget to the maximum, and not on stimulating the economic growth.

Under the new IMF program, the government has vowed to change the taxation system, rather than individual taxes, and to do so in the nearest future. By the end of April, the blueprint of the State Fiscal Service (SFS) reform should be developed, aimed at restructuring the network of tax and customs offices, laying off inefficient officials, creating a business environment that would not depend on political influences and the free interpretation of the laws by tax and customs officials, automating customs operations the maximum, and so on. The recent dismissal of the SFS top managers and the investigation into their activities is a sign of determination of the authorities. The government expects the new tax system to be launched on January 1, 2016.

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Pension reform. To this day, changes to pension legislation have been adopted along with tax changes with the intention of reducing the deficit of the Pension Fund of Ukraine (PFU) and its burden on the budget, but this did not solve the problem holistically. Such changes included reducing pension benefits for working pensioners, imposing taxes on high pensions, increasing the length of service required for retirement, and so on. A radical reform of the pension system requires working in two directions: bringing wages out of the shadows (reducing the unified social tax rate was the right move, which, according to preliminary data, already yielded the first results in the first quarter of this year) and stimulating the economic activity that would save Ukrainian youth from emigration by reducing the average load on retirees per employee and increasing the tax base for the unified social tax, but will require comprehensive economic reforms. Under the new agreement with the IMF, the government undertook to draft the blueprint of a comprehensive reform of the pension system by September 2015 and to submit to the Parliament the bills necessary to make the pension reform work as soon as the beginning of the next year.

Public finance administration reform. This is about changing the proportions and the areas of the public finance use. First of all, it's about the increased transparency of public procurement. Last year, a new law on public procurement was adopted in Ukraine. This February, ProZorro electronic procurement system was launched, which is now used by a growing number of government agencies. According to Dmytro Shymkiv, transparent procurement should result in saving 10-20% of the public funds and significantly reducing the field left for corruption in the market amounting to about $200 bn annually.

It is also about fiscal decentralization. The Strategy 2020 provides that in 5 years, the share of the local budgets in the consolidated budget of the country will be 65%. Today, it is about 20%. And, as it turned out, even the narrow margin amounting, according to various estimates, to UAH 25-45 bn and allocated by the government in the 2015 budget to increase the revenues of local budgets exceeds their disbursement budgets. The decentralization process requires changing the attitudes and the thinking of the local authorities, building the necessary financial and industrial infrastructure, and a long period of time to achieve success. However, the first steps in this direction have already been taken, and the ice has been broken. Let's hope that the real decentralization drive will pick up pace.

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Alongside, the social security system is undergoing a radical reform. This reform is necessary to bring tariffs for energy and utilities to economically sound levels and to switch the respective sectors of the economy to operation based on market principles. The 2015 budget reserves UAH 24 bn for subsidies to the most vulnerable social groups. This amount, according to the Minister of Social Policy Pavlo Rozenko, would allow for softening the blow dealt by the increased bills to the incomes of about 4 mn Ukrainian families. In order to distribute such large amount to so many people, the social security system should work much more efficiently, and social aid programs should be modified. The government undertook to implement the necessary changes already this year.

In addition to these three areas, the structure of consolidated budget expenditures will undergo a series of transformations. For example, in the medium term, the government plans to bring the labor costs of government employees to 9% of GDP at the account of layoffs and the optimization of public administration processes. Capital expenditures are planned to grow from 1% of GDP in 2014 to 3% in 2018. This will provide the material basis for the modernization of the country's infrastructure. There is a number of other initiatives as well.

Financial sector reform. The National Bank of Ukraine is busy working on changes designed to transform the financial sector from the tool for sucking money out of the economy into a source of investment and economic growth. Last year, NBU restructuring was launched, which will result in the NBU budget reduced by half this year already, and the number of employees gradually decreased by tens of percents. Under the new IMF program, the National Bank undertakes to develop by the end of April a number of amendments to the Law on the National Bank aimed at optimizing the structure of the regulator, increasing its independence, and improving its balance.

The restructuring of the banking system is underway, and insolvent banks and financial institutions involved in money laundering are being removed from the market, including the so-called "conversion centers" used to convert company funds into cash to provide for the needs of the shadow economy. The law on strengthening the responsibility of related parties adopted recently is aimed at making the work of financial institutions more transparent. The NBU undertook to draft amendments to the legislation and the regulatory documents designed to limit the volume of lending provided by banks to related parties. These loans have a negative effect on the asset quality of financial institutions, significantly increasing credit corporations' unsystematic risks and resulting in large-scale bank insolvency in times of crisis.

Besides, the National Bank plans to develop a strategy to reform the entire financial sector in addition to the banking one. This refers to the stock market, insurance companies, investment and superannuation funds, etc. The work in this area is just beginning.

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State property Restructuring and privatization. The government has taken the first steps towards restructuring state enterprises and preparing them for privatization. New managers selected by an independent commission on a competitive basis were appointed to major state-owned companies. Today, the government is working on a strategy to reform public companies, to be completed by the end of May 2015, and on taking their inventory, improving corporate governance, and mitigating budget risks associated with their inefficient operations. By the end of August, the government plans to make an inventory of the real estate owned by the state, intending to increase its administrative efficiency. In the medium term, it is planned to considerably reduce the list of state properties that cannot be privatized, to prepare most public companies for privatization, and to restructure the rest.Deregulation and business development. In addition to changes in the tax laws relieving the business of the burden of dealing with the state, many other transformations are underway. Last year, the number of permits required to register a business was reduced from 143 to 85, and obtaining them was made easier. The procedure for closing a business was simplified for individual entrepreneurs. A moratorium was introduced on planned inspections of businesses by regulatory authorities. A step by step plan to eliminate regulatory barriers has been developed, which, among other things, provides for reducing the number of supervisory bodies from 56 to 28, and their functions from 1032 to 680 by this midyear. The government also plans to establish a mechanism to prevent new barriers from emerging after a significant number of them is eliminated.

In addition to these horizontal reforms, significant changes are taking place in individual sectors of the economy, including energy, agriculture, and infrastructure. These vertical transformations, like the ones mentioned above, are intended to launch the economic growth mechanism, eventually resulting in higher earnings of every Ukrainian. Time will show whether the reforms will succeed. Basing on the deadlines set by the government, we will know it at the beginning of the next year.


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